Are We Worried?
Is the multifamily market at its peak? Will interest rates force the real estate values to come down? Are you worried about [insert your favorite concern]? Is it the time for investors to stay on the sidelines? We get these questions all the time.
Experts say the real estate market has been going up for almost nine years straight. Experts say we are overdue for a correction. Experts say we should be fearful. The truth is, while nothing can go up forever, nobody really knows the timing of the reversal.
We all can recall numerous cases when the so-called “experts” were wrong. In 2008 for example, Goldman, the #1 investment bank on the Street, was calling for $200 oil price. The oil was around $140 back then. Lehman, at the very same time, was saying oil is about to decline to $93. How could two premier banks with an army of analysts and great access to information arrive to such dramatically different conclusions?
Anyone remembers Meredith Whitman and her call for a muni market collapse – the collapse that never materialized? It was all over the news in 2010. We won’t even mention what experts were saying about last year’s presidential election!
The point that we are trying to make here – you can know a lot about the market, study it for a long time and still turn out to be wrong. On a macro level, the best position an investor can take, in our view – is that the reality is unpredictable. You can, however, usually tell, on a relatively basis, if the pendulum has swung too far one way or another and adjust your investment behavior accordingly.
One of my favorite investors that greatly influenced my own investment philosophy is Howard Marks, the co-founder and Chairman of Oaktree Capital Management. I could not resist including a couple of his quotes here because I think they are very relevant to the situation we are currently in and the topic of our discussion:
“There are no facts about the future, just opinions. Anyone who asserts with conviction what he thinks will happen in the macro future is overstating his foresight, whether out of ignorance, hubris or dishonesty”.
“….rather than “what inning”, I’d suggest investors ask if thing are or are not in an extended state. Is psychology depressed, average or euphoric? Is the capital market shut tight, normal or unthinkably generous? These are the questions that can be answered in a helpful way, not how close the game is to being over. No one knows the answer to the latter”
“Most people don’t want to tempt fate by saying that things will go well forever, and in fact they know they won’t. It’s just that they can’t decide what it is that will go wrong. The truth is that while I can enumerate them, the obvious candidates (changes in oil prices, interest rates, exchange rates, etc.) are likely to already be anticipated and largely priced in. It’s the surprises nobody can anticipate that would move the markets most if they were to happen. But (a) most people cannot imagine them and (b) most of the time they don’t happen. That’s why they are called surprises”
Yes, the real estate market, multifamily included, has been going up for many years in a row now and the easy money have been made. Still, in the environment that we find ourselves in today, we do not believe that staying on the sidelines is a great alternative. Our motto at Sunsail: think for yourself, rely on your own judgement, be cautious, underwrite conservatively and hedge your bets. Our goal #1 is preservation of capital. We believe if we focus on that, the returns will take care of themselves. To answer our own question – no, we are not worried about what the future may bring. Our reasoning is explained below.
We don’t have a gun to our heads to invest
I remember hearing one of my other favorite investors, Seth Klarman who runs the Baupost Group, at an investment conference in Boston a few years ago. He was asked how to avoid failure in the investment business. His answer was simple but very powerful: “if there is nothing to do…do nothing!”. A lot of people just cannot stay disciplined and patient and wait for the right pitch, as Warren Buffet says. They feel a very strong desire to get involved even if investing conditions are less than optimal and the required risk-reward parameters are not met. As true value investors at heart, we are not worried about overextending ourselves. We subscribe to Warren Buffet’s philosophy that “an investor needs to do very few things right as long as he avoids big mistakes”. In layman terms, it can be translated as: “don’t do stupid things”! We are good at that.
In the investment business, not everyone has a luxury of “doing nothing”. Let’s take mutual funds or hedge funds for example. They cannot just sit on cash and stay uninvested. If you are an investor in one – you would immediately be asking: “what am I paying you for all these fees for God’s sake?!”. And you would be right to ask. With multifamily syndications – being “uninvested” is not an issue; we raise money deal by deal – not as a blind pool of money. As such, unless we find a deal that meets our strict investment criteria – “there’s nothing to do” and we are under no real pressure to deploy capital.
Fundamentals of multifamily value-add strategy are solid
Our focus on is on Class B and Class C apartment complexes. While there has been a lot of construction of Class A properties, building of new Class B/C properties is in most cases uneconomical and this resulted in the shortage of affordable and workforce housing nationwide. This situation is unlikely to change any time soon. The demand for affordable housing is only growing and the supply remains constrained. Even in the market downturn, most Class B/C assets should perform reasonably well. In some areas, rent concessions will have to be offered, but we believe the vast majority of the stabilized properties will continue to generate positive cash flow even in a downturn scenario. As such, Class B/C multifamily will remain on the top list of investors’ preferred assets.
At Sunsail, our #1 goal is preservation of capital and as such, we are truly committed to conservative underwriting. That could mean that it might take us a relatively long time to find deals that meet our investment criteria but we are in no rush. We won’t put neither our own nor our investors’ capital to work unless “there’s something to do” and we are getting properly compensated for the risk we are taking. We cannot control the world around us but we are in control of our own actions.
Class B/C multifamily value-add strategy is relatively uncorrelated to the overall market. Our underwriting always assumes the increase in the exit cap rate during the target hold period and the increase in interest rates. We are not relying on the compression in the cap rates to achieve our targeted returns and we don’t assume steady interest rates. Returns are primarily driven by the so-called “forced appreciation” – and main drivers that are not correlated to the market: execution of the operational turnaround, renovations, repositioning of the asset and the ability to raise the below market rents to be in-line with the market.
In our underwriting, we always plan for capital expenditures’ budget reserves – we plan to raise more money that we think we actually need so we are properly reserved and have liquidity “cushion” in case things don’t go as planned. Additionally, we look to set aside a certain portion of the monthly operating cash flow for the operational reserves’ account. Moreover, if the market nosedives and we decide that it doesn’t make sense to continue implementing our strategy – we always have an option to stop the renovation of the units and just sit on cash unlit we can readjust our strategy or return it to investors.
To summarize, while we don’t disagree that we are late in the business cycle, we are not paralyzed by fear and we are not staying on the sidelines – we are actively looking for new deals. At the same time, we believe this is not a time to be a hero and conservative underwriting is integral to today’s investors success. We believe that Class B/C multifamily value-add strategy still has very strong risk-reward potential especially as compared to other asset classes.